Australia, NZ dollars on defensive as spreads shrink

On Thursday, the Australian and New Zealand dollars found themselves under defensive pressure as European debt markets instilled more confidence in the US dollar. The widening spread between French and German 10-year bond yields, the largest since 2012, added to the woes of local bonds. The strain was felt across Italian and Greek bonds as well, dragging the euro to a 22-month low against the Australian dollar, currently trading at A$1.6039.

This downward trend also weighed on risk sentiment, propelling the US dollar higher. The Australian dollar is now hovering between $0.6990 and $0.7004, with support at the recent 13-week low of $0.6904. The New Zealand dollar, meanwhile, is at $0.5605, having slumped 0.4% overnight. A break below the 10-month low of $0.5581 could trigger a further decline towards at least $0.5485.

An FX analyst at CBA, Carol Kong, anticipates the shrinking spread will push the Australian dollar to $0.6600 by early next year. She attributes this to less positive and eventually negative interest rate differentials, partly due to the expectation of a Reserve Bank of Australia cash rate cut in 2027. However, current market expectations still include at least one more RBA hike by mid-next year, with no signs of cuts in 2027.

Kong warns that a sharp equity market correction, a significant rise in bond yields, or an escalation of geopolitical conflict that dampens global growth prospects could quickly undermine risk appetite and propel AUD/USD lower.